Many of the institutional factors said to impede growth in Mexico—labor market rigidities, inefficient financial institutions and deficiencies in the rule of law—are also present in China. In Why Have Economic Reforms in Mexico Not Generated Growth? (Staff Report 453), Timothy Kehoe and Kim Ruhl examine whether standard economic theory can explain why China has grown so much more rapidly than Mexico in the past two decades.

Both countries have opened themselves to trade and foreign direct investment; Mexico implemented additional market-oriented changes, such as fiscal reforms and privatization of government-operated firms. “In spite of these reforms, Mexico’s economic growth since 1985 has been modest, at best,” write Kehoe and Ruhl. “This growth is especially disappointing if we compare it with that of China.” Real GDP per working-age person grew by 510 percent in China from 1985 to 2008, but only 10 percent in Mexico. “In this paper, we ask why Mexico’s reforms did not result in higher rates of economic growth.”

To answer that question, the authors develop a theoretical framework in which countries far behind the “industrial leader”—the United States over the past century—can grow rapidly for a limited period without major reforms to either labor markets or legal and financial systems. By adopting the stock of knowledge created by industrial leaders, they hypothesize, poorer countries can increase total factor productivity and experience a period of rapid “catch-up” growth.

At some point, however, institutional constraints bind, and growth in GDP per working-age person will level off at a trend rate of about 2 percent per year. Only by enacting significant reforms can countries experience growth rates that exceed the trend rate, but “the possibilities for such catch-up growth depend on the distance of the developing economy from the (industrial leader) frontier.”

Mexico experienced a period of this catch-up growth from 1953 to 1981, enjoying 3.8 percent annual growth in real GDP per working-age person. Thus, despite its rapid recent growth, China was still substantially poorer than Mexico in 2008, with a GDP per working-age person of $7,986 compared with Mexico’s $20,755.

The authors point out that a small part of the perceived “growth gap” between China and Mexico is apparent rather than real. They calculate that changes in China’s terms of trade may be causing Chinese consumers to benefit less from growth than real GDP measures would indicate. Real GDP is invariant with respect to changes in the terms of trade. In contrast, real gross domestic income (GDI) adjusts the trade balance using the import price deflator: Exports are valued in terms of the amount of imports they could purchase. Using World Bank data to estimate the effect of China’s terms of trade on GDI suggests that Chinese real GDP overstates the growth in real GDI by almost 8 percentage points over the decade considered. The economists also adjust for the welfare benefits of consuming a greater variety of goods. These measurements seem to indicate that Mexico has reaped substantial benefits from trade liberalization despite its relatively slow GDP growth.

But such measurement issues are a small part of the overall conundrum. Increases in productivity drive economic growth, argue the economists, and so an explanation of why Mexico stagnated while China grew rapidly must focus on productivity trends in both countries and reasons for those trends. “Our theory suggests that the factors that currently impede growth in Mexico, such as inefficient financial institutions, and insufficient rule of law, and rigidities in the labor market, do not yet do so in China because China has not yet reached a sufficient level of economic development,” they write.

These factors will become more important as China grows further, Kehoe and Ruhl predict, and observers should expect sharp deceleration in China’s growth if it fails to significantly reform its economic and legal institutions.